Your new best friends: compound interest and growth.

*Disclaimer: this isn’t professional financial advice — just regular, educational info to help you learn! Investing comes with risks (yes, even losing money), and past performance DOES NOT guarantee future results. Always do your own research!

Yet again, you are hearing someone talk about "returns" and "compounding" as reasons you need to invest your money. What do they actually mean when they say that, though?

Well, they are talking about returns on investments, which are either a result of compound interest or growth. Yes, I know this is still semi-jargony. So, what are compound interest and growth, and why are they so magical?

First, simple interest (the type that doesn't compound) is money you are paid in exchange for lending your money. Now this doesn't mean you have to physically give your money to someone; rather, depending on where it is stored, it may already be being borrowed.

For example, you deposit 100 dollars in a high-yield savings account (HYSA) that earns 5% interest over a 1-year period. After 1 year in the account, your money would have earned 5 dollars, bringing your account total to 105 dollars versus the original 100 you put in.

• The bank used your 100 dollars -- in a pool of money for lending, investing, etc. -- and in exchange for using it, paid you 5 dollars of interest.

In order to earn compound interest, you would take that 105 dollars and "re-invest" it by keeping it in the account. If you did this, at the end of year 2, you would have 110 dollars and 25 cents. As the 5% interest rate would have been applied to the 105 dollars, rather than the original 100 dollars.

• You earned compound interest by investing both the original amount (the principal) and the interest you earned on it: the 5 dollars.

• Note: I am using a 1-year interest period in this example for simplicity. However, compounding frequency can vary, with banks often compounding interest monthly or even daily.

  • This means if your 100 dollars made 1 cent today, tomorrow your 100.01 dollars will be what the interest will be made on, rather than the original 100 dollars.

Ok, so you may be saying to yourself: "Who cares about 10 dollars made on a 100 dollar investment?". Well, the short answer is we do, and you should too. While 10 dollars may feel like peanuts, let’s see how you feel after an example with larger numbers.

See the equation below for what happens when compound interest is applied to 10,000 dollars invested over a 30-year period with an interest rate of 4%. (The rationale behind 4% for this example was to remain conservative and allow for different asset allocations).

A = P (1 + r/n) ^nt

A = 10,000 (1 + 0.04/1)^1 x 30

A = 10,000 (1.04)^1 x 30

A = 10,000 x 3.243

A = 32,340

A = Final amount

P = Original investment ($10,000)

r = Interest rate (4% as a decimal is 0.04)

n = Number of times interest is compounded per year (using 1x/year for this example)

t = Number of years (30)

So, as we see in this equation, if you put 10,000 dollars today in a high-yield savings account (HYSA) -- I know, scary big number just using it to show the power of compounding interest -- you would have around 32,340 dollars in 30 years. And all you did to earn 22,340 dollars was let the 10,000 dollars sit there!

Your money made you money while you slept!

Now, to clarify, only certain investments earn compound interest. Such investments include high-yield savings accounts, certificates of deposit (CDs), bonds (if interest is reinvested manually), etc.

However, those investments that don't earn compound interest, such as stocks, index funds, and real estate, see something called compound growth. 

The reason it is called compound growth, as opposed to compound interest, is that you aren’t reinvesting interest. Instead, you are investing the money made on the investment, which can be a dividend, appreciation, etc.

Let’s look at an example:

If you invested 100 dollars in the stock market and made a 7% return after 1 year (an average based on historical market returns), you would have 107 dollars. You could then reinvest the 107 dollars and have 114.49 at the end of the second year. This is the exact same math we saw above with compound interest; however, in this case, it would be compound growth. The reason for this is that the 7 dollars earned from the stock market was not an interest payment, so you aren’t reinvesting interest.

• Appreciation of a stock is when it becomes more valuable than the price you bought it at. So, when you want to sell it, you will make a profit (that being the difference between what you paid for it and what you sold it for).

• Dividends are payments made to a shareholder (aka you, who owns some of their stock), usually from their profits. Meaning that if the company did well, they reward those who hold their stock (they can be paid out even if the company had a bad year); however, it is up to them if they want to do that.

Looking at both examples, we see that the HYSA that is earning compound interest is also seeing compound growth. However, the stock market investment you have is only seeing compound growth and not compound interest, as it is not earning interest.

Please note: the key difference between compound growth and compound interest is that compound growth can happen through reinvested returns, but compound interest only occurs when interest is reinvested.

So, now we see why compound interest and compound growth are our new best friends!

p.s. time is the best friend of compounding, as we saw with our 30-year example. wealth is built slowly when investing, so start as early as you are able and let the money do the work for you!

As Warren Buffett famously said: "If you don't find a way to make money while you sleep, you will work until you die". So dark, I know, but not untrue (and now you know why the cover photo is a bed)!